Solow, Piketty and the problem with bank bailouts and deposit insurance

Robert Solow (of 1956 Solow Growth model fame) has written a highly illuminating review of Thomas Piketty's widely discussed book "Capital in the Twenty-First Century". In it Solow sets out what he terms the "rich-get-richer dynamic", which he believes Piketty has demonstrated is intrinsic to Market Capitalism (and which Piketty and Solow both regard as justifying wealth taxes).

The essence of the case is this. Piketty attempts (with at least moderate success) to show that as economies grow, the rate of return on capital exceeds the growth rate. If, as is normal, we regard total economic output as divided between capital and labour, that mean's the share of the total economic pie taken by capital will rise over time. Furthermore, those with the most accumulated capital tend to secure the highest returns (because of better diversification and higher economies of scale in investing). So those with the most accumulated wealth will see their wealth grow materially faster than does the economy as a whole, meaning the richest get richer faster than everyone else, and inequality (in terms of the gap between richest and the median, or richest and poorest) increases.

There are lots of things to be said here about Bill Gates and Mark Zuckerberg not being the product of wealth inherited since the 18th century, about how globalisation and an increasing population allows a given idea to spread ever-quicker so wealth from novel sources overtakes older wealth (and don't assume that expansion of the economy or population must stop before we escape the earth to the stars, either…), and similar points – some of which Piketty responds to convincingly and some of which he does not. But let us take the point, as Solow does, in its own terms.

Now remember: this is argued (quite plausibly) to be an intrinsic long-term feature of Market Capitalism. It isn't just that the rich-get-richer dynamic applies in recessions or ages of austerity or anything of that sort. Rather, over centuries the richest have got richer fastest and will do so even faster in the future.

Piketty and Solow appear to believe that the key problem here is the increasing inequality. But even if you couldn't give two hoots about inequality (as I don't), this may seem morally problematic. After all, one theory of the moral defence of market capitalism is that it is intrinsically meritocratic and promoting of social mobility – those with the best ideas or most talent or who work hardest can achieve high rewards. If instead those who happen to inherit the most wealth from their parents make the largest gains in their wealth without needing to do any work at all, it's tougher to claim that market capitalism is intrinsically a merit-rewarding system.

It seems to me that there is a version of something that at least might look like market capitalism that would indeed render itself morally problematic in this way. If the system were such that some folk, without doing any work at all, would become increasingly wealthier than anyone else, living risk-free off the fruits of previously-accumulated capital, Piketty and Solow would have a point. But in a healthy capitalist system that will not be true.

How so? Well, capitalism got going precisely when (in the 16th and 17th centuries) a series of legal reforms and developments in moral thinking embedded the concept that lending at interest (the providing of capital that was not managed by the capital-provider, the "capitalist") could not be risk-free. Bankruptcy law, limited liability, the abolition of selling oneself into slavery to service debts, and a number of other reforms meant that no lender could (or should ever be able to) guarantee repayment of a debt made at interest.

Imagine for a moment that that is how market capitalism actually works, then think of the Solow-Piketty critique? Those with the most wealth – the most capital to invest – get a rate of return that is higher than the growth rate of the economy, but they do not do so passively and risk-free. Instead, they must choose how to allocate their capital between various intrinsically risky projects. The return to capital then is a form of reward for work – for the work of deciding what is the best project to invest in and for bearing the risk that investments go bad.

If this is how market capitalism works, the Solow-Piketty critique has much less bite. Instead of saying "Those with the most accumulated wealth become richer than others faster, without doing anything", we must say that "capitalism allows the richest to become richer faster than others, to the extent that they make (and as a reward for) wise investment choices."

But is it how market capitalism really works? One standard 19th century critique of capitalism was that it might all look morally robust in theory, with the idea that the richest might become poor if their investments fail and so forth, but in practice matters would not work like that. In practice, these critics said, the wealthiest would use the political influence that their wealth gave them to make sure that, if their investments ever looked like going bad, the state would intervene (taxing the poor and the middle classes, if necessary, to provide the funds) to protect the rich from downside risk, keeping them rich.

We saw the classic playing out of this dynamic in recent years in the banking crisis from 2007 on. In that case the "capitalists" in question were those that lent money to banks – bank depositors and bank bondholders. Bank deposit insurance and bank bondholder insurance makes the state into an instrument for defending the vested wealth of the rich. It was felt politically impossible, across most of the developed world, to allow bank depositors or bank bondholders to lose any money.

If that is how the system works – if the state is used to prevent those with wealth from losing any of it – then the Solow-Piketty critique will have bite, and the moral defence of lending money at interest developed in the West in the 16th and 17th centuries will collapse.

Now of course those that intervened in 2007-on to keep the rich rich did not believe that was all that they were doing. They were persuaded that if bank depositors and bank bondholders were allowed to lose any money, then the poor would lose out as well – e.g. there might be mass unemployment. I believe their belief in this was totally wrong, but that's not the point. Let's suppose they were right. In a Piketty-type world, such a problem will get worse and worse over time. As the richest become richer and richer, more and more ordinary people will depend for their livelihoods upon servicing the needs of a smaller and smaller number of rich people. Then allowing any rich person to go bankrupt or even to take a modest fall in wealth will imply a disruption in the livelihoods of more and more ordinary people.

The implication is that, for market capitalism to work, the state will have to be willing to see periods of (potentially ever-escalating) disruption to the lives of ordinary people as the price for preventing the wealthiest being pure passive rentiers. It is not (and morally cannot be) the job of the state to keep the rich rich, even if by doing so the state softens the impact on the poor of the rich becoming poorer. If it does so, market capitalism will not work – either in terms of efficiency or in terms of moral defensibility.